How China’s ‘Currency Manipulation’ Enhances the Global Role of the U.S. Dollar

But it's not quite that simple. In fact, Beijing benefits from the dollar’s dominance.

By Michael Pettis

On April 16, Zhou Xiaochuan, the governor of China’s central bank, the People’s Bank of China, once again set off alarm bells during a speech at the International Monetary Fund (IMF). “Starting from this April,” he announced, “China has released foreign exchange reserve data denominated in the SDR in addition to the USD.” He went on to say: “We will also explore issuing SDR-denominated bonds in the domestic market.” After many years of announcing monthly the value of its foreign currency reserves only in dollars and renminbi, the Chinese currency, the People’s Bank has begun to announce their value in Special Drawing Rights (SDRs), a weighted index set by the IMF consisting of the dollar, euro, Japanese yen, pound sterling, and, beginning in October, the renminbi. This, according to a People’s Bank statement, “would also help enhance the role of the SDR as a unit of account.”The announcement raised eyebrows among many central bank watchers. Within days, Hong Kong’s South China Morning Post warned that the bank’s latest move confirmed its strategic goal to “end the US dollar’s hegemony” and “forge a new global financial order.” In an article for the financial publication MarketWatch, research analyst David Marsh tried to suggest a wider strategy: “The world’s second-largest economy is embarking, pragmatically but steadily, toward enshrining a multicurrency reserve system at the heart of the world’s financial order.”

Marsh, like many other analysts who have repeated the popular but confused story about the rise of the renminbi and the decline of the dollar, may have misunderstood the role of reserve currencies within the global balance of payments. Whatever Beijing may think it is doing, its economic policies since the 1990s have, in fact, enhanced the reserve role of the dollar. To do otherwise would have undermined China’s economic development. A reduced reserve role for the dollar would, in fact, make China’s already difficult economic rebalancing — shifting its economy away from investment and toward domestic consumption — costlier than ever.

The dubious privilege of hegemony

While many complain about the “exorbitant privilege” Washington enjoys from the dollar’s hegemonic status, the U.S. government actually receives very little economic benefit and pays a substantial economic cost for having the dollar as the world’s reserve currency. These costs have become that much greater as a result of the June 23 Brexit vote, which saw the dollar strengthening as frightened money poured into the United States.Before discussing the costs, it might be useful to consider the purported benefits. These four are the most widely discussed:Lowering U.S. government borrowing costs. An otherwise excellent 2009 report by the McKinsey Global Institute claims “the United States can raise capital more cheaply due to large purchases of US Treasury securities by foreign governments and government agencies.” This seems reasonable at first: More demand for government bonds should drive prices up. But, as we will see, foreign purchases also automatically increase the supply of dollar debt. Were this not so, we would have to conclude absurdly that driving up a country’s current account deficit, the obverse of its capital account surplus, would automatically lower that country’s borrowing cost.Allowing Americans to consume beyond their means. This interpretation implies, as the St. Louis Federal Reserve Bank erroneously explains in a 2016 paper, that “the United States has become a net borrower from the rest of the world because it has run a persistent current account deficit.” Here is how Yale University professor Stephen Roach puts it: “America has made its own bed. The culprit is a large saving deficit; [t]he country has been living beyond its means for decades and drawing freely on surplus saving from abroad to fund the greatest consumption binge in history.”This is almost exactly backward. Yes, developing countries are usually unable to save enough to fund their investment needs and so run current account deficits. This was true with the United States in the 19th century, whose deficits were financed mainly by the United Kingdom — which also supplied the U.S. shortage of investment and consumer goods with a British current account surplus. But U.S. investments have long ceased to be constrained by a lack of savings. Today, the United States runs a current account deficit only because foreign money flows into the country and pushes up the dollar.This need not be just a U.S. problem. Any country with a credible currency will “consume beyond its means” whenever foreign central banks or foreign institutions try to stockpile its currency. However, most countries refuse the privilege, often indignantly, because it unfairly forces up their currencies or otherwise compels them to “consume beyond their means.”Providing seigniorage benefits. Currency notes are effectively interest-free loans to the issuing government. The value of this benefit, however, is almost negligible and has nothing to do with reserve status. Any credible currency can enjoy the benefits of seigniorage — the profit a government makes by issuing currency. For example, the 2002 creation of the 500 euro note caused a significant shift in seigniorage benefits to the European Central Bank, as money launderers, drug dealers, and others trying to hide their wealth switched from hoarding $100 bills.Allowing the United States to sell economic insurance. As the United States intermediates low-risk, high-quality inflows into riskier outflows during times of stability, it effectively earns a risk premium for which it pays out during periods of instability. This creates real value both for the United States and for countries that choose to buy this insurance. However, this value does not depend on reserve currency status at all, but on the perceived stability of the U.S. economy as a safe haven.These four “privileges,” in other words, are at best weak and usually confused. In the 1960s, Valéry Giscard d’Estaing, later France’s president, accused the United States of exacting “exorbitant privilege” after the dollar shortage of the 1940s and 1950s, which was only resolved by the massive dollar grants under the Marshall Plan and a political decision during the Cold War to allow Europe to earn dollars through protective measures. What makes the continued intellectual obtuseness of many Europeans extraordinary is that it is only the private sector analog of exorbitant privilege — unconstrained foreign capital inflows into the United States — that has permitted Germany to continue policies that have crippled German demand, which, after devastating peripheral Europe, are now resolved within the United States as European capital pours into the country.Open and flexible financial markets in the United States allow Germany to pursue policies that are among the most irresponsible in modern history. This is what exorbitant privilege brings, and this is why the dollar will continue to be the dominant reserve currency for the next several decades (unless the U.S. government itself decides to prevent or limit foreign accumulation of dollar reserves).It is also why the SDR, and even more so the renminbi, cannot become important reserve currencies. Many in Beijing may not understand that the cost of reserve currency status is foreign appropriation of domestic demand. Despite small-scale policies to increase renminbi holdings among foreign central banks, Beijing’s economic policies prevent foreigners from appropriating China’s already-too-weak domestic demand and so make it impossible for the SDR or the renminbi to ever become more than a minor reserve currency.

The dollar rules everything

To see why, we only have to go through the balance of payments exercise. The SDR is a constructed currency. If a central bank buys an SDR-denominated bond issued by the IMF, and the IMF hedges it by buying the requisite amount of bonds in dollars, euros, yen, sterling, and, soon enough, renminbi, this is no different than if the original central bank simply bought the requisite amount of bonds in dollars, euros, yen, sterling, and renminbi. In 2009, the People’s Bank website published a famous essay by Zhou in which he asked, “[W]hat kind of international reserve currency do we need to secure global financial stability and facilitate world economic growth?” His answer suggested a significantly enhanced role for the SDR and was widely interpreted as an assault on U.S. dollar hegemony. Strangely enough, if the People’s Bank really wanted SDR exposure, it could easily get it by buying those currencies separately according to the formula set out by the IMF.But it never did. Instead, it mostly bought dollars. When a central bank chooses which currency to buy, it is also determining the direction of net trade flows. If the People’s Bank had bought other currencies, those related countries would have had to match the inflows on the capital account with larger current account deficits, or smaller surpluses, which would have triggered resistance in those countries.This resistance, of course, is the problem. Given their much more limited economic flexibility and less ebullient financial systems, few other countries could have sustained the consequent trade deficits, and they would have almost certainly moved aggressively against China to limit the development of unfavorable trade balances. China, in other words, chose to buy dollars not because it had to, but because if it did not export capital, its domestic unemployment would have soared. And no other country besides the United States was willing or able to run deficits of the necessary magnitude.It may be useful to consider an actual case. When the People’s Bank tried to accumulate yen in 2011, rather than welcome the chance to steal away some of the dollar’s exorbitant privilege, Tokyo demanded that the People’s Bank stop buying its currency and aggressively bought dollars, effectively trying to ensure that its increased share of “exorbitant privilege” was immediately passed on to the United States.Because a current account surplus is by definition equal to the excess of savings over investment, the gap between the two in Japan would have had to narrow by an amount exactly equal to People’s Bank purchases. Here is where the exorbitant privilege breaks down: If Japan needed foreign capital because it had productive investments at home that it couldn’t finance for lack of savings, it might have welcomed Chinese purchases. But like any other advanced economy, Japan did not need foreign capital to fund productive domestic investment.If People’s Bank yen purchases couldn’t force up Japanese investment, by necessity Japanese savings had to decline in line with its current account surplus. There are only two ways the inflows could cause Japanese savings to decline. First, a domestic consumption boom could cause the Japanese debt burden to rise, which Tokyo clearly didn’t want. Second, Japanese unemployment could rise, which Tokyo even more clearly didn’t want.There is, in short, no way Japan could have benefited from People’s Bank purchases of its yen bonds. Only the United States permits unlimited purchases of government bonds by foreign central banks — not because, however, it is immune to the problems Japan and other advanced countries face. Like them, the United States can easily fund productive domestic investments without foreign capital, and so rather than cause productive investment to rise, foreign investment causes domestic savings to fall, which can only happen with a rising debt burden or rising unemployment.In fact, foreign investment is only good for an economy if it brings needed technological or managerial innovation or if that economy cannot otherwise raise funding for domestic productive investment. If neither holds — and they hold in developing economies only, not advanced countries like the United States — foreign investment always forces the recipient country to choose between a higher debt burden and higher unemployment.This is the great irony of the aftermath of the global financial crisis. China, Russia, and France want to lead the charge to strip the United States of its exorbitant privilege, and Washington resists. And yet, if Washington were to take steps to prevent foreigners from accumulating U.S. assets, the result would be a sharp contraction in international trade. Surplus countries, like Germany and China, would be devastated, but the U.S. current account deficit would fall with the reduction in net capital inflows. As it did, by definition the excess of U.S. investment over savings would have to contract. Because U.S. investment wouldn’t fall, and in fact would most likely rise, savings would automatically rise as lower unemployment caused GDP to grow faster than the rise in consumption.

The savings slip-up

But what about the United States’ extremely low savings rate? Doesn’t it consume beyond its means, as Roach wrote, leaving it savings-deficient and reliant on Chinese and European savings to fund the U.S. fiscal deficit? “[T]he real reason the US has such a massive multilateral trade deficit,” Roach wrote in April, “is that Americans don’t save.”This is one of the fundamental failures in understanding the balance of payments. As counterintuitive as it may seem at first, it is not low U.S. savings that suck in foreign capital, which then forces foreigners to run current account surpluses. On the contrary, the U.S. savings rate is low precisely because it must balance foreign capital inflows.

This is an arithmetical necessity. If foreigners increase capital exports to the United States, the excess of investment over savings must necessarily rise to balance the import of foreign savings. This is a requirement of the balance of payments, and the money pouring into the United States following the shock of the Brexit vote, for example, will push U.S. savings down further, probably partially as the consequence of a rise in unemployment. Productive investments in the United States are not constrained by a lack of capital — and have not been since the late 19th century — and so the excess savings foreigners export to the United States cannot result in higher U.S. investment. U.S. savings must necessarily fall, and they do through only one of two mechanisms.The first mechanism occurs during economic booms, including, most famously, in the United States and peripheral Europe before the 2008-2009 crisis, wherein foreign capital inflows drive up asset prices, making households feel richer. This encourages increased consumption funded by rising debt. Monetary authorities usually gladly accommodate rising debt because higher domestic consumption generates jobs that replace those lost by workers producing the tradable goods displaced by the rising current account deficit.During the subsequent contraction, set off once asset prices and debt levels rise too high, the second mechanism comes into play. High debt and declining asset prices force households to cut back on consumption so that businesses lay off workers. Rising unemployment forces down savings as unemployed workers continue to consume.As long as the United States is the only country willing and able to run the current account deficits that result from foreign accumulation of dollars, the dollar will be the only important global reserve currency. And as long as other economies try to goose domestic growth or reduce domestic unemployment by forcing up exports relative to imports, either U.S. debt will be higher or U.S. growth will be lower and unemployment higher. This is why the United States will eventually limit foreigners from accumulating dollars for their reserves.If central banks were forced to accumulate SDR, the United States would absorb just under 42 percent of central bank capital exports, equal to the dollar’s share of the SDR, as opposed to the roughly two-thirds it currently must absorb. Europe would be forced to absorb almost 31 percent and China, Japan, and the United Kingdom between 6 and 11 percent.Even this is too much, however. It would be far better if countries that allowed domestic policy distortions to create domestic demand deficiencies were prevented from forcing these distortions onto their trading partners. It is surprising that Washington has not yet taken the lead in doing so — not so much by forcing cumbersome changes in the rules governing international trade, but by taxing or otherwise limiting foreign access to U.S. government bonds when purchases are driven primarily for trade advantage.The logic is inexorable. As the global economy grows relative to that of the United States, it is only a matter of time before Washington is forced into defensive action. The only question is how much economic pain and domestic unemployment the United States is willing to accept before it acts. As long as the dollar is easy to acquire in near-unlimited amounts, foreign countries with weak domestic demand can simply buy dollars and force their domestic demand deficiencies onto their trading partners. Until then, it doesn’t matter whether or not the People’s Bank tries to improve the SDR’s visibility. It is entirely against China’s economic interests for the SDR to replace the dollar — let alone for the renminbi to do so.

Strategas writes that increasing deficit could limit a possible U.S. fiscal stimulus package.

By Strategas Research Partners.

Photo: Pixabay

The Obama Administration has increased its estimate for the current fiscal year budget deficit to $600 billion. This revised deficit forecast was up from a previous estimate of $530 billion and the prior estimate suggested that the deficit would decline this year.

Thus, we are seeing a rapid change in the expectations for the federal budget deficit. Even if the deficit comes in a little below $600 billion, the year over year increase for this year will be about 25%.

Strategas anticipated this change as Congress passed significant fiscal policy at the end of 2015 in order to boost GDP ahead of the 2016 election. But there is complacency from both policymakers in Washington and investors over the deficit.

The belief is that the deficit is under 3% of GDP and therefore manageable. But the current trends suggest the deficit will continue to widen as tax collections have all slowed considerably.

And demand for spending continues to grow. The importance of this is whether it will impact the size of the fiscal stimulus package in 2017. Investors across the globe are anticipating the US will act on stimulus next year as every new president gets flexibility to move on fiscal policy. But a growing deficit may restrict the size of the package and is worth keeping an eye on.

Corporate tax collections have been the weakest part of the budget with tax revenues declining year over year. This is a function of declining corporate profits and new tax incentives enacted as part of the 2015 budget deal. The budget agreement allowed companies to write off 50% of their capital equipment purchases as a way to spur capital expenditures in the non-energy sector. Since the provision went into effect, manufacturing orders rebounded and the stocks most levered to this provision are outperforming the S&P 500.

Defense spending was hit with three different types of cuts over the past six years including the drawdown of war spending, a freeze on the base Defense budget in 2011, and sequestration which came into effect in 2013. The 2015 budget deal relaxed those sequestration caps which will allow for Defense spending to increase for the first time on a year-over-year basis since 2011. It seems likely we are at the end of the six-year declining budget cycle given the geopolitical challenges facing the US.

The increase in government spending will likely benefit the companies that depend on government spending for their revenue growth.

Like the Romans, we’re supposedly ruled by laws, not by men. In Rome, the law started with the 12 Tablets in 451 BCE, with few dictates and simple enough to be inscribed on bronze for all to see. A separate body of common law developed from trials, held sometimes in the Forum, sometimes in the Senate.When the law was short and simple, the saying “Ignorantia juris non excusat” (ignorance of the law is no excuse) made sense. But as the government and its legislation became more ponderous, the saying became increasingly ridiculous. Eventually, under Diocletian, law became completely arbitrary, with everything done by the emperor’s decrees—we call them Executive Orders today.I’ve mentioned Diocletian several times already. It’s true that his draconian measures held the Empire together, but it was a matter of destroying Rome in order to save it. As in the U.S., in Rome statute and common law gradually devolved into a maze of bureaucratic rules.The trend accelerated under Constantine, the first Christian emperor, because Christianity is a top-down religion, reflecting a hierarchy where rulers were seen as licensed by God. The old Roman religion never tried to capture men’s minds this way. Before Christianity, violating the emperor’s laws wasn’t seen as also violating God’s laws.The devolution is similar in the U.S. You’ll recall that only three crimes are mentioned in the U.S. Constitution—treason, counterfeiting, and piracy. Now you can read Harvey Silverglate’s book, Three Felonies a Day, which argues that the average modern-day American, mostly unwittingly, is running his own personal crime wave—because federal law has criminalized over 5,000 different acts.Rome became more and more corrupt as time went on, as has the U.S. Tacitus (56-117 AD) understood why: “The more numerous the laws, the more corrupt the nation.”

Social

Along with political and legal problems come social problems. The Roman government began offering useless mouths free bread, and later circuses, in the late Republic, after the three Punic Wars (264-146 BCE). Bread and circuses were mostly limited to the capital itself. They were extremely destructive, of course, but were provided strictly for a practical reason: to keep the mob under control.And it was a big mob. At its peak, Rome had about a million inhabitants, and at least 30% were on the dole. It’s worth noting that the dole lasted over 500 years and became part of the fabric of Roman life—ending only when wheat shipments from Egypt and North Africa were cut off by the Vandals at the beginning of the 5th century.In the U.S., there now are more recipients of state benefits than there are workers. Programs like Social Security, Medicare, Medicaid, food stamps, and numerous other welfare programs absorb over 50% of the U.S. budget, and they’re going to grow rapidly for a while longer, although I predict they’ll come to an end or be radically reformed within the next 20 years. I recognize that’s a daring prediction, given the longevity of the dole in Rome.

Demographics

The Empire appears to have suffered a demographic collapse late in the 2nd century, during the reign of Marcus Aurelius, at least in part because of a plague that killed on the order of 10% of the population. Ancient plagues are poorly documented, perhaps because they were viewed as normal happenings. But there may be other, subtler reasons for the drop in population. Perhaps people weren’t just dying, they also weren’t reproducing, which is much more serious. The rising Christian religion was puritanical and encouraged celibacy. Especially among the Gnostic strains of early Christianity, celibacy was part of the formula for perfection and knowledge of God. But of course, if Christianity had been effective in encouraging celibacy, it would have died out.The same thing is now happening throughout the developed world—especially in Europe and Japan, but also in the U.S. and China. After WW II, American women averaged 3.7 children. Now it’s 1.8; in parts of Europe, it’s 1.3. Part of that is due to urbanization and part to an understanding of birth control, but a growing part is that they just can’t afford it; it’s very expensive to have a kid today. And I believe another major element is a new religious movement, Greenism, which is analogous to early Christianity in many ways. It’s now considered antisocial to reproduce, since having kids raises your carbon footprint.

Intellectual

The essential anti-rationality of early Christianity poisoned the intellectual atmosphere of the classical world. This is true of not just religions in general, but the desert religions of Judaism, Christianity, and Islam in particular—each more extreme than its predecessor.In late antiquity, there was a battle between the faith of the Fathers of the Church and the reason of the philosophers. Christianity halted the progress of reason, which had been growing in the Greco-Roman world since the days of the Ionian rationalists Anaximander, Pythagoras, Heraclitus, and others, right up to Aristotle, Archimedes, and Pliny. Knowledge of how the world worked was compounding, albeit slowly—then came to a stop with the triumph of superstition in the 4th century. And went into reverse during the Dark Ages, starting in the 6th century.Christianity used to hold that anything that seems at odds with revealed truth or even with the extrapolations of revealed truth is anathema, the way much of Islam does today. The church drew generations of men away from intellectual and scientific pursuits and toward otherworldly pursuits—which didn’t help the Roman cause. It can be argued that, if not for Christianity, the ancient world might have made a leap to an industrial revolution. It’s impossible to make scientific progress if the reigning meme holds that if it’s not the word of a god, it’s not worth knowing.For nearly 1,000 years, revealed beliefs displaced science and reason. This started to change only in the 13th century with Thomas Aquinas, an anomaly in that he cleverly integrated the rational thinking of the ancient philosophers—Aristotle in particular—into Catholicism. Aquinas was lucky he wasn’t condemned as a heretic instead of being turned into a saint. His thought had some unintended consequences, however, which led to the Renaissance, the Industrial Revolution, and today’s world. At least until Aquinas, Christianity slowed the ascent of man and the rise of rationalism and science by centuries, in addition to its complicity in the fall of Rome.As the importance of science has grown, however, religion—or superstition, as Gibbon referred to it—has taken a back seat. Over the last 100, even the last 50 years, Christianity has fallen to the status of a back story for Santa Claus and quaint, albeit poetic, folk wisdom tales.

Emerging markets aren’t a haven—but they look like a compelling alternative to the bigger concerns that still lie in developed markets

By Richard Barley.

One month on from the Brexit vote, and one week after the Turkish coup attempt, emerging markets show no signs of flagging. In fact, the surprise success story of the year appears to be gathering momentum.Emerging-market stocks are handily beating their developed peers, with the MSCI Emerging Markets index up 9.7% in the year to date, versus 2.6% for the MSCI World. Away from the Turkish lira, currencies have retained their poise: the Russian ruble is up 13% against the dollar, the Brazilian real 21% and the South African rand 9%. Bonds are proving no slouch: J.P. MorganJPM0.33%’s EMBI Global sovereign bond index has returned 12.5%; its local-currency peer, the GBI-EM nearly 14%.What were headwinds for emerging-market investors are turning into tailwinds. The performance in stocks marks a departure from near-continual disappointment since 2010. The rally started in part because investor sentiment toward emerging-market assets was extremely poor: a small reversal in flows could shift the dial. Now the taps are open: in the week to July 20, retail investors put $10.2 billion into emerging bonds and stocks, the second-largest amount on record, J.P. Morgan notes.Growth, meanwhile, could be looking up. The latest International Monetary Fund forecasts brought downgrades for developed economies, but not for emerging markets: the growth gap, which has been narrowing since 2011, is set to widen again. Fund manager NN Investment Partners says that its growth momentum indicator, based on data from 20 leading emerging-market nations, has turned positive for the first time since 2014.

Meanwhile, what is bad news for Turkey, with the lira down more than 5% year to date and its credit ratings under pressure, could be good news for other high-yielding emerging markets, CitigroupC0.11% strategists note. Turkey’s troubles are country-specific: that argues for rejigging positions within emerging-market funds, not pulling cash out of the asset class altogether.

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Of course, risks remain. But one worry—tighter monetary policy from the U.S. Federal Reserve—doesn’t look quite as scary as it did. Even though Brexit now seems unlikely to deliver a Fed on permanent hold, U.S. policy makers are clearly moving gradually. And many emerging countries have used the time since the so-called taper tantrum of 2013 to improve their positions.China remains the elephant in the room—on several fronts. Chinese growth is vital for emerging markets and the globe, and the imbalances that the economy has built up, including high corporate debt levels, continue to be a concern. A reassessment by China of its currency policy, too, would shake markets. But this is a threat to global investors, not just emerging markets.The bigger concerns for investors still lie in developed markets, where the aftermath of the financial crisis is undermining long-held political assumptions. Emerging markets aren’t a haven—but they look like a compelling alternative.

This map illustrates that two different economies coexist within Mexico. Mexico’s National Institute of Statistics and Geography generated this data by measuring several development indicators, including housing infrastructure, basic furnishings, overcrowding, health, education and employment levels. The higher a state’s overall standard of living, the higher its ranking.

Economic activity in each state correlates with these rankings. Mexico’s central and northern states are home to advanced industry, attract foreign direct investment and/or are strategically located near strong trade flows associated with the U.S. border. Meanwhile, the southern states’ economies are more dependent on agriculture and primitive industry, with higher numbers of informal, low-wage laborers. Government figures show that from 1980 to 2014, per capita GDP in central and northern states grew by about 50 percent. In the south, this figure increased a mere 9 percent.

In particular, Chiapas, Guerrero and Oaxaca stand out. The share of residents living in extreme poverty in these states ranges from 61 percent to 74 percent. The Mexican government is currently creating the conditions needed to spark growth and has planned special economic zones in Chiapas Port, Lázaro Cárdenas Port and the Isthmus of Tehuantepec, which connects the Gulf and Pacific coasts. Included in the plans are tax incentives, duty-free customs benefits, streamlined regulatory processes, improved infrastructure and better logistical connections to the rest of Mexico.

For economies in the northern and central states to remain robust and the south to further develop, Mexico needs to maintain good trade relations with the United States. About 80 percent of Mexico’s exports go to the United States and are exchanged within the NAFTA framework. However, the future of NAFTA has been brought into question in the United States, a topic we will further explore in our upcoming Deep Dive.

The business cycle is peaking, with no interest-rate increase. The central bank has blown it. Still, better late than never.

By Edward P. Lazear.

The Federal Reserve is in a tough spot. When the central bank’s policy makers meet next week, many observers expect them to leave interest rates untouched, perhaps citing the shock of Britain’s vote to leave the European Union. The difficulty is that many indicators, particularly from the labor market, suggest that the U.S. economy is peaking and that the recovery from the Great Recession is nearly complete. This is bad news—and not only because the summit is too low. It also means the Fed has blown it.At this point in the business cycle, the Fed would normally be holding steady, looking ahead to a time when it might cut interest rates. Instead it is preparing for a prolonged path of increases, even though the best time to raise rates may have already passed. Historically, the central bank increases its target federal-funds rate as the economy recovers, beginning within two to three years of the recession’s end—but often sooner. It then cuts the target around the time that the peak is reached. The exception is the current recovery, during which the target and actual rates remained flat for more than seven years. After only a minor increase in December, rates are still near zero. The Fed has fallen seriously behind the curve. No one can divine exactly when the economy will peak. But most of the evidence suggests that the moment is near. The unemployment rate is 4.9%, and it hit 4.7% in May, figures consistent with full employment. Job growth tells the same story. When the economy is in recovery mode, job growth exceeds population growth, making up for the employment lost during the recession. That slows as the peak approaches, until job growth just keeps pace with population growth. That’s where we are now.

To keep up with population growth, the economy needs to create about 130,000 jobs a month. During the past three months, job growth averaged 147,000. That’s down from an average of 229,000 a month last year. The trend suggests that the labor market is in full-employment equilibrium. Further evidence suggesting the economy has begun to level off: The hiring rate reported by the Bureau of Labor Statistics now hovers at 3.5%, down from a high of 3.8% last December. Or consider wage growth. During the early stages of recovery, real wages are flat, but they increase as the labor market tightens and full employment approaches. Although wage growth has been less than spectacular, the Bureau of Labor Statistics reports it at 2.6% during the past year, above the rate of inflation.Finally, GDP growth is steady or slowing. The first quarter rate of 1.1% is below the already anemic recovery average. Figures for the second quarter, even if considerably better, won’t do much to change that picture.At this stage of the business cycle, it is unrealistic to expect that the economy will soon become more robust and better able to withstand rate increases. Even if we are at a growth plateau rather than a peak, the postrecession drop in unemployment to 4.9% from 10% will not be matched by a future drop to 0%.Yet the Fed’s unwillingness to raise rates can be explained, if not defended. If this is a peak, it is too low a summit. Growth rates have fallen short of the prerecession average and cannot make up for lost ground. Further, the labor market has not returned to full strength: The employment rate, which reports the ratio of those with jobs to those in the working-age population, was 63.4% in December 2006 but now stands at only 59.6%. Some of this difference reflects an increasing numbers of retirees. But the rate for those of prime working age, 25 to 54, is also 2 percentage points below prerecession highs. Additionally, the hiring rate during this recovery never reached the 4% peak attained in 2006, during the previous boom.Each time it appears appropriate to raise rates, some new shock hits the world economy, Brexit being the most recent example. Fundamentally, the Fed fears a repeat of 1938, when a recovering economy was sent into a second strong contraction as a result of central-bank tightening. Still, interest-rate increases are overdue. If this is the peak of a business cycle, or close to it, rates should have gone up long ago. The Fed has already waited too long to move back to a more normal posture, one that would permit aggressive monetary policy when it is next needed. Now the Fed’s position must be better late than never—hoping that the costs of poor timing will be small.Mr. Lazear, a former chairman of the Council of Economic Advisers (2006-09), is a professor at Stanford University’s Graduate School of Business and a Hoover Institution fellow.

What Gold, Silver, And Bitcoin Are Telling Us About Stock, Bonds, And Currencies

by: Andrew Hecht

Summary

- Gold and silver bull markets.

- Bitcoin - a validation of weak fiat paper currencies.

- Currencies all move lower.

- Bonds - interest rates are not going up. They are going lower.

- Stocks - it is a bad time to be overvalued.

2016 has been a year for trading rather than investing. Over the first six weeks of the year, the S&P500 dropped 11.5%. By the end of the first quarter, it was back up and closed at the end of March with a 0.77% gain. At the end of June, the critical equity index had posted a 2.69% gain on the year. Those who held their noses and bought the dip that took the market to lows on February 11 profited handsomely, so far.

So many retirement and investment accounts mirror the performance of the S&P 500 index and the index put in a respectable performance after the carnage seen during the first month and a half of this year. However, there are some ominous signals that the second half of the year could be difficult for equity markets. In fact, other markets could be telling us that dark clouds are gathering, and stocks could be in real trouble in the weeks and months ahead. It is an excellent time to take stock of those stock positions, in a couple of weeks your portfolio results for 2016 could look a lot different than they do today.

Gold and silver bull markets

Fear and uncertainty have gripped markets across all asset classes in 2016 increasing volatility. The action in precious metal markets has been a direct result of the volatile nature of the political and economic landscape around the world.

Early in the year, the gold market gave the first indication that something was underfoot. Gold rallied out of the gate in 2016 while many other commodity markets had yet to make significant multi-year lows.

As the weekly chart highlights, COMEX gold futures opened 2016 around the $1060 per ounce level. Last week gold traded to highs of over $1375 per ounce, the highest level since March 2014. The over 29% increase in the price of gold has been a sign that investors and traders have sought safe-haven assets for their capital.

The action in silver, a more speculative precious metal, has been even more impressive.

The weekly silver chart illustrates that the precious metal that opened at the beginning of 2016 at the $13.80 per ounce level appreciate to highs of over $21 last week, an increase of 52%. The price increases in both silver and gold have been validated, from a technical perspective, by the rise in open interest to all-time highs. Open interest is the number of open long and short positions in the futures market and the increase in market activity over recent months has been proof of the fear and uncertainty that prevails in markets. Last Friday, after a strong employment report the prices of both gold and silver corrected lower only to bounce back higher later in the session; a sign of real strength.

Bitcoin- a validation of weak fiat paper currencies

Gold and silver have a long history as hard assets or real money. In fact, these precious metals have been around as means of exchange or currencies long before any of the current currencies of the world existed.

Over recent years, a new form of currency has captured the attention of many around the world.

Cryptocurrency is a computer-based means of exchange that become more popular particularly with the millennial generation. Bitcoin is the dominant cryptocurrency, and it has appreciated dramatically over recent months.

As the annual chart of Bitcoin shows, it has moved from $430.05 on December 31, 2015, to over $652 as of last Friday, an increase of over 51%.

Gold silver and Bitcoin all have one thing in common; central banks and monetary authorities around the world cannot create more of these currencies as they are truly pan-global means of exchange. The price action in all three is telling us something significant about the current state of the global economic and political landscape.

The Carden Smart Wealth Indices provide an emotion-free view of markets and can dampen volatility when market activity flashes warning signs. These indices may serve as excellent predictive tools at a time when alternative assets are flashing ominous signals to markets.

Currencies all move lower

The weekly chart of the U.S. dollar index shows that the greenback has appreciated against all the key currencies since May 2014.

A stronger dollar is traditionally bearish for the value of gold and silver as well as other hard assets. However, in 2016 these precious metals have taken off to the upside despite the fact that the dollar remains far above levels seen in 2014. If gold, silver and Bitcoin have rallied in dollar terms, it means that they have exploded in other currencies as the other main foreign exchange instruments remain weak against the U.S. currency.

In 2016, we see a decline in the values of all paper money when compared to precious metals and the cryptocurrency.

Bonds- Interest rates are not going up, they are going lower

The debasement of currency values around the world is a direct result of the central bank monetary policies. Since the global financial crisis in 2008, policies of slashing interest rates and quantitative easing or buying back debt by central banks have become the norm. The U.S. QE policy ended over a year ago, but interest rates remain just above zero after the first rate hike in nine years last December. The Fed promised to increase rates 3-4 time in 2016 but because of a myriad of domestic and foreign economic issued that have yet to act.

In Japan and Europe, interest rates are in negative territory. The Chinese economy has slowed.

In the summer of 2015, Europe faced a default by the Greek government. The bailout put additional strains on the European economy. A massive refugee influx from the Middle East and North Africa into Europe has made a bad situation worse when it comes to Europe's struggling economy. Most recently, the U.K. voted to exit the European Union, which led to a precipitous drop in the value of the pound and worries about other member nations leaving the Union. Now it appears that Italian banks are in a financial mess, and whispers of an Italian exit from the E.U. have stoked new fears of a total breakup and breakdown in economic order.

All the while, government bond prices have been climbing given the artificial put option in place by the central banks of the world.

The quarterly chart of the U.S. 30-year bond speaks for itself.

Central banks are running out of monetary tools fast. The two most prominent central bankers in the world, Europe's Mario Draghi, and the Fed's Janet Yellen have been cautioning government leaders that monetary policy by itself is not sufficient without fiscal policies to stimulate the economy, reduce saving and increase borrowing and spending. Talk of helicopter money has slowly been creeping into the discourse from central bank officials and respected economists.

Meanwhile, while interest rates are at the lowest level in history, the easy money policies have been hampered by the banks that have tightened credit policies. The only people that can borrow in this environment are those who do not need the money. The catch-22 of the current state of monetary policy has left central bankers and government officials scratching their heads on what to do next. The one thing they all seem deathly afraid of is abandoning accommodative policy for fear that it will throw the global economy into a brutal recession.

In the wake of Brexit, it appears that interest rates are once again heading lower and further into uncharted waters. Low rates have caused capital to find any home possible as the debt markets offer little, no or negative yields around the world.

Stocks- It is a bad time to be over-valued

Money continues to flood the equity markets with interest rates at such low levels. Last quarter, corporate earnings were less than exciting. At the same time, stock prices are trading at rich multiples compared to past years.

The CAPE ratio is far higher than its mean and median levels dating back more than 100 years meaning equity valuations are too high. Given the current state of the global economy, they may be not only high but in bubble territory. Capital growth in the equity markets is dependent upon earnings. The current economic landscape makes it tough for companies to grow revenues. Therefore, many have turned to stock buyback programs or trimming expenses to pump up short-term profits and share prices. This merry-go-round cannot go on forever, and economic conditions must improve, or we will begin to see massive downdrafts in stock prices and the flow of money into equities will stop. We have already seen two such stock market tremors in August of 2015 and at the beginning of this year. Those tremors could be the harbinger of what awaits us in the months ahead.

Currency values are questionable given the appreciation of gold, silver and Bitcoin over recent months. Bond prices have risen to a level where a concrete ceiling is in place, and the only reason they are so high is that governments keep printing more money to buy more bonds and keep interest rates low for the very few with the ability to borrow. Meanwhile, stock prices are at levels that would be high even if the global economy was chugging along in healthy fashion, which is it not.

Precious metals are an effective fear barometer. It is a scary time in the global economy, and the citizenry of many countries are voicing their concerns at the polls as we just witnessed in the United Kingdom. The trend of political change at a time when economic foundations appear so weak could add more volatility to markets in the weeks and months to come with the U.S. Presidential election on the horizon. That is what gold, silver and Bitcoin are telling us about the global economy. It is only a matter of time before stocks, bonds, and currencies begin to crumble under the weight of pressure and artificial central bank accommodation.

The Bank of Japan8301-1.66% is retreating into some much-needed introspection. And while it prepares to do this, it threw markets a not very meaty bone to chew on.The central bank on Friday underwhelmed overexcited expectations for yet another big bang of monetary stimulus. The Bank of Japan announced a paltry 3 trillion yen ($28.5 billion) increase to its purchases of exchange-traded funds to 6 trillion yen in a bid to boost asset prices. It also doubled down on a relatively minor U.S. dollar lending facility to give Japanese companies a nudge to buy assets overseas. Markets seem to have taken the disappointment in stride, at least early on. Stocks rose, no doubt helped by news of the ETF purchases. Banks and insurers did best, with investors relieved that negative rates weren’t being taken lower. The yen did strengthen somewhat but remains weaker than it did in the throes of Brexit’s mayhem.The BOJ’s limited actions Friday were telling of the bank’s limits in practical terms. It didn’t boost its already massive bond-buying, possibly because of diminishing returns and because it is reaching its limits it terms of supply. Other asset markets are too small for the central bank to step into in a big way. Negative rates, unveiled in a shock manner in January, haven’t gone down well. ETFs were one safe corner to tap.

A slew of fresh economic indicators points to Mr. Kuroda’s conundrum. Inflation continues to head away from the bank’s 2% target, despite ever-tightening labor markets. The unemployment rate fell to its lowest point in decades, and the job-to-applicant ratio rose. But there are no signs of wage increases.The Bank of Japan’s intention to reflect on its broader project is no doubt aimed at figuring out why it has done so much yet accomplished so little, especially when it comes to households. New strategies might include ways the BOJ can bolster Prime Minister Shinzo Abe’s imminent—and possibly large—stimulus package. News of the fiscal package this week may in fact have taken pressure off Mr. Kuroda to reach deep into his bag of policy tricks to prove his might. A moment’s insight could be worth a lot.

Shock proof. The resilience of markets is standing out as a defining feature, with setbacks shortlived and ultimately providing investors with a buying opportunity.

In a climate where everyone worries about the next nerve-jangling event, the past 12 months have been marked by bouts of turmoil and predictions of gloom that ultimately fall short.

The list includes China’s currency devaluation last August, the rout in commodity prices which triggered a plunge in the price of energy junk-rated debt and the global growth scare in January.

Recent slings and arrows have also failed to live up to their fearful billing for markets. Initial alarm cast by the long shadow of Brexit and bad loans made by Italian banks has been replaced by equanimity. In plain performance terms, we have a record high for the S&P 500, while the FTSE All World index has climbed 18 per cent from its nadir in February.

One obvious reason for the ebbing resonance of market shocks is the easy money policies of central banks, that subdue both interest rates and market volatility. In a world where some $12tn of bonds yield less than zero, a number of investors believe the limits of central banking have long been reached. Welcome to the era of investing in an earthquake zone, where market tremors are routine and few think the big one will ever occur. Testing the shock proof status of markets therefore requires a departure from the current playbook that has dominated finance in the wake of the 2008-2009 crisis.

Eight years of austerity and a prolonged fall in central bank borrowing rates and bond yields have failed to deliver sustained economic growth. Hence the rise of populist politics, while calls for fiscal stimulus are steadily growing. It is a path being taken by Canada, with a post-Brexit UK looking to loosen the shackles. Both US presidential candidates, notably Donald Trump, are also focusing on the fiscal side of the stimulus equation.

Meanwhile, the test bed over the past two decades for policy experiments has been Japan and there, talk of “helicopter money”’ — whereby the budget deficit is financed by a permanent increase in the central bank’s monetary base and not via government bonds — is the current hot topic of debate.

Of the 160 fund managers surveyed by Bank of America Merrill Lynch this month, 39 per cent expect “helicopter money” in the next 12 months. That is up from 27 per cent in June.

For the broader global economy, any significant fiscal stimulus through infrastructure spending, vouchers for consumers and/or some combination of tax cuts is seen boosting growth and pushing up inflation expectations. Patrik Schowitz, global strategist at JPMorgan Asset Management, says fiscal stimulus calls for buying cyclicals, rather than looking at dividends and long duration bonds. “The question is how much stimulus would be required to convince investors that it works,” he adds.

Given the extreme hunt for yield in recent years, the prospect of major fiscal expansion, particularly if undertaken by leading economies in unison, would amount to a significant shock for plenty of portfolios.

Piling into dividend-paying equities and long-dated bonds has helped these asset classes achieve gains of 20 per cent alone since last summer. An ever shrinking pool of positive yielding bonds has spurred a mad dash for any asset with some kind of fixed return.

Currently, investors such as pension and sovereign wealth funds are pumping money into emerging market bonds at a record pace, lured by yields that remain well above those of developed world sovereigns.

The result? A classic crowded trade, and, as market history tells us, these episodes never end well. A decisive flick of the fiscal switch to loosen austerity would herald a stampede from the best performing sectors of global markets. The ensuing surge in market volatility would prompt investors to sell their holdings based on risk management models — known as a value-at-risk (Var) shock — in order to avoid losses. “There’s clearly a push away from austerity towards fiscal stimulus and a Var shock is a risk here and could be evolving as we speak,” says Chris Watling of Longview Economics. And we have felt the Var tremors before, notably during the summer of 2013 with the taper tantrum and then, from last April, when the 10-year German Bund yield rose from just above zero per cent to near 1 per cent by early June. As yields and volatility rise, investors embark on a rotation into cyclicals, but as we saw last summer, this type of churning in equities is subsequently overwhelmed by broader market turmoil.For now, the push for sustained fiscal measures as monetary policy reaches its limits, remains more talk than action. The potential for sparking a massive rush for the exit from what has been a relentless search for yield cannot be ruled out. One can only hope that markets simply experience another tremor and not the big one.

If you know the other and know yourself, you need not fear the result of a hundred battles.

Sun Tzu

We are travelers on a cosmic journey, stardust, swirling and dancing in the eddies and whirlpools of infinity. Life is eternal. We have stopped for a moment to encounter each other, to meet, to love, to share.This is a precious moment. It is a little parenthesis in eternity.